Chapter 2

Job Order and Process Costing

In order to understand job order costing, we will return to the example given in Chapter

1, Elway. As you recall, Elway manufactures canoes. Basically, the steps in the process are as

follows:

(1) A computer­ driven saw cuts out parts of the canoe based on selected patterns that are

fed to the saw. The cut out parts are thin plywood sheets.

(2) The sheets are assembled to form the canoe. In this area, screws and glue are used to

put the parts together.

(3) Finally, in the last area, the finished canoe is painted and dried. Illustration 2.1 shows

this process.

The amount of plywood used for each canoe is 100 square feet at $1 per square foot. It

takes 5 hours at $20/hour to assemble the parts and each canoe gets 108 screws and 2 quarts of

paint. The plywood is a direct cost since it can be directly associated with the manufacture of the

canoe. The same is true of the 108 screws and the two quarts of paint. Assuming the stainless

steel screws are $.10 a piece and the paint is $6.00 per quart, the screws cost 108 X $.10 =

$10.80 and the paint is 2 X $6.00 = $12.00 for a total of $22.80. Thus, the total direct materials

for each canoe is $122.80.

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 Another direct cost associated with each canoe is the assembly labor cost. This cost is 5

hours at $20/hour to give $100/per canoe. Thus, $100 is the direct labor cost of the canoe. So,

we have direct materials of $122.80 and direct labor of $100 to give a total of $222.80. These

costs are called prime costs. As we noted in chapter 1, these are variable costs.

What other costs are incurred in manufacturing the canoe? There are some indirect

materials costs such as sandpaper for the canoes and oil for the saw. We say indirect because

they are not directly associated with the manufacturing of a specific canoe, but rather several

canoes. There are other indirect costs such as the foreman’s salary, the cleanup crew, the quality

control engineer that periodically samples completed canoes for quality assurance, heat,

electricity, etc. These total costs, as we stated in chapter 1, add up to $275,000. We lump all

these costs into one and call it overhead. Overhead is a fixed cost. So, we have prime costs of

$222.80 per canoe and $275,000 worth of overhead. How do we get the $275,000 down to each

canoe? We apply it.

Overhead application can be quite complicated, so pay careful attention to this. We said

that the overhead is a fixed cost of $275,000. We assign this overhead to each canoe based on an

activity that is clearly associated with the manufacture of that canoe. Well, there are two items

directly associated with the manufacture of each canoe, direct material and direct labor. Let’s go

with direct labor. Remember there are 5 direct hours associated with each canoe, so how do we

apply the $275,000 given these 5 direct labor hours? We start with the anticipated production

level of canoes for the year. Let’s say we anticipate producing 2,000 canoes a year. If we

produce 2,000 canoes, we will need 5 X 2,000 or 10,000 direct labor hours. To get the overhead

application rate, we divide $275,000 by 10,000 direct labor hours to get $27.50 for each direct

labor hour.

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 Since each canoe takes 5 direct labor hours, the amount of overhead applied to each

canoe is 5 X $27.50 = $137.50. So the total cost for each canoe is:

direct materials $122.80

direct labor 100.00
overhead 137.50
TOTAL $360.30
As we noted previously, direct materials and direct labor are called prime costs. Direct labor and

overhead are called conversion costs. Let’s pause for a minute and reflect on this. Remember,

we were trying to figure out how to translate $275,000 worth of overhead to an individual canoe.

We selected an activity directly associated with the canoe, direct labor hours. Based on direct

labor hours, we came up with an application rate of $27.50 per direct labor hour. How is the best

way to envision this? We believe the best way to see all this is to think of the canoe going through

the manufacturing process. The first step is sawing, then assembly, then painting. Visualize the

partially completed canoe moving across the production floor. As it does, it absorbs overhead

similar to absorbing heat, light, etc. When the canoe is complete, it not only has its direct costs,

but also the “absorbed” overhead.

A manufacturing company calls these three categories of costs: direct materials, direct

labor and overhead, inventoriable costs. In others words, these are the costs that make up the

three categories of inventory. Raw materials consist of the direct materials used to manufacture

a canoe. Work in process inventory consists of all three costs, but not 100% complete. Finished

goods are products that are 100% complete and contain all three costs. These inventoriable costs

are contrasted with period costs. Period costs are items such as selling and administrative

expenses. Illustration 2.2 reflects this discussion.

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As you can see from this illustration, the direct materials, direct labor and overhead costs go into

inventory. In the case of direct materials, it is the raw materials inventory. Then all three costs

go into work-in-process, then finished goods. When the finished goods are sold, they become the

cost of goods sold – an expense on the income statement. All other non­ inventoriable costs are

considered period costs and are shown after the gross margin is calculated.

As we have just seen, the income statement for a manufacturing firm shows a cost of

goods sold figure, but getting to that figure is much more complicated than the merchandising

firm. Illustration 2.3 shows the schedule of cost of goods manufactured for Calks, Inc.

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As you can see, Illustration 2.3 goes through the calculation with direct materials, i.e.beginning and

purchases less ending inventory, to give us the direct materials used in manufacturing. Then

labor is added followed by a breakdown of the overhead items. Adding direct materials, labor

and overhead gives us the total manufacturing costs for 2014. We are assuming here that the

actual overhead costs are exactly the same as the applied overhead. Once we have the

manufacturing costs for 2014, we then go through the work in process calculation taking the work

in process at the end of 2013 and adding to it the manufacturing costs for 2014 which gives us

total manufacturing costs (this year’s costs as well as the beginning of the year). Subtracting the

work in process inventory at the end of 2014, gives us the cost of goods manufactured in 2014.

But we are not through yet. How does the cost of goods manufactured number get to the cost of

goods sold in the income statement? To explain that, look at Illustration 2.4 Income Statement

for Calks, Inc.

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Finally, we get to see how the cost of goods manufactured goes to the cost of goods sold.

Illustration 2.4 shows how this is done. The cost of goods manufactured is added to the

beginning finished goods inventory. Then the ending finished goods inventory is subtracted to

give the cost of goods sold. All of this illustrates how a manufacturing firm shows the cost of

goods sold in the income statement. In reality, the manufacturing firm shows one line for the

cost of goods sold, but shows the cost of goods manufactured and the changes in the finished

goods inventory as supporting documents.

Before we leave job order costing, let’s go back to the overhead discussion. In that

discussion, we noted that overhead is applied based on some activity such as direct labor.

Illustration 2.3 assumed that the applied overhead and the actual overhead were the same. We

did that for illustrative purposes, but that almost never happens in reality. Let me give you a

simplistic example. Let’s use the numbers from Elway. Remember, the overhead costs for

Elway totaled $275,000. We assumed annual production of 2,000 canoes. It takes 5 direct labor

hours at $20/hour for each canoe. Annual production of 2,000 canoes equates to 10,000 direct

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labor hours. We divided the $275,000 by 10,000 to give us $27.50 per direct labor hour. Since

there are 5 direct labor hours associated with each canoe, the overhead applied was 5 X $27.50 =

$137.50 per canoe. Now, think about it for a minute. If our production for the year is 1,800

canoes instead of 2,000, we will have applied overhead of 1,800 X $137.50 per canoe to give

$247,500. Yet our actual overhead is $275,000. So we have underapplied overhead by the

difference between $275,000 and $247,500 or $27,500. On the other hand, if our production for

the year is 2,200 canoes, our applied overhead is 2,200 X $137.50 per canoe to equal $302,500.

So we have overapplied overhead by the difference between $302,500 and $275,000 or $27,500.

To explore this further, what happens to the under or overapplied overhead? Let’s take

the overapplied overhead first. By applying $302,500 to our production when our actual costs

are $275,000, we have overstated our costs of goods manufactured. In other words, the work in

process, finished goods and cost of goods sold are all overstated. Theoretically, we should go in

and reduce the costs of each of these accounts, but in practice, most manufacturing firms make a

simple adjustment to the cost of goods sold account rather than the three accounts. In this case,

the cost of goods sold for the year would be reduced by $27,500. Now, let’s look at the other

example. Assuming the 1,800 canoe production, we have understated the three accounts by

$275,000 - $247,500 = $27,500. Again, most manufacturing firms would make an adjustment to

one account – cost of goods sold. In this case, we have understated cost of goods sold by

$27,500; therefore, we would increase the cost of goods sold account by that amount.

A final word on job order costing. Although our illustrations show a job order process

where we are building a product, for example, a canoe, many of our modern manufacturing

facilities do not work exactly that way. Many modern facilities use robots to assemble products.

As a result, direct labor may be minimal, but overhead may be substantial. A robotic process,

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however, does not change the fundamental cost structure associated with manufacturing. The

essential costs are still direct materials, direct labor and overhead. It’s just that in the modern

plant the portions and levels of these costs may be quite different from our illustrations.

Our next topic for discussion is process costing. Process costing involves a process in

which large quantities are produced. Good examples are gallons of paint, gallons of ice cream,

gallons of gasoline, cans of tuna fish and loaves of bread. The costing concept is the same

as job order costing. We are applying direct materials, direct labor and overhead to a unit of

production, but instead of one job like a canoe, there are many units like gallons of paint.

In process costing, the major difficulty is costing the work in process. For example, let’s

assume we are manufacturing paint in a one department company. The process consists of

adding all the materials – alkyd resin and pigment into a large mixer, then mixing the ingredients

together and canning the results in one gallon containers. All of this is accomplished by one

machine that mixes and pours into an automated line of empty gallon cans. Let’s assume the

process produces 20,000 gallons of paint that are completed in every respect and 2,000 gallons of

paint that are 50% complete (these 2,000 gallons have just begun the mixing process). What was

produced? We would say 20,000 completed gallons and 2,000 gallons 50% complete. We

would not say 22,000 gallons because the 2,000 gallons 50% complete are not the same as 2,000

completed gallons. So how do we work around this dilemma? We express the output of the

process in terms of equivalent units, not physical units. So what is an equivalent unit? It is work

done on a physical unit. When all of the work is done, we have a completed physical unit. But

as we have just seen, this may not be the case and as a result we have to deal in equivalent units

to measure the cost of work in process. Illustration 2.5 helps to explain the equivalent unit idea.

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 Illustration 2.5 shows that there were 20,000 physical units started and completed and

there were 2,000 physical units 50% complete. The question is how do we value the finished

goods inventory as well as the work in process inventory? Using the equivalent units idea, we

see that of the 2,000 work in process units, all received a 100% dose of direct materials, so the

equivalent units for direct materials for these 2,000 units is 2,000. These 2,000 units received a

50% dose of direct labor and a 50% dose of overhead. As a result the equivalent units for direct

labor are 1,000 and for overhead are 1,000. Looking at the cost information, you see the total

production costs to account for are $102,950 consisting of $24,200 in direct materials, $31,500 in

direct labor and $47,250 in overhead. Dividing each category of costs by the equivalent units in

that category gives us the costs per equivalent unit. So we are now ready to cost the finished

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goods inventory. The finished goods inventory is 20,000 units x ($1.10 + $1.50 +$2.25) = 20,000 x

($4.85) = $97,000. The work in process is 2,000 units. How do we break that down?

Work in process:
Direct materials: 2,000 equivalent units X $1.10 = $2,200
Direct labor: 1,000 equivalent units X $1.50 = $1,500
Overhead: 1,000 equivalent units X$ 2.25 = $2,250

Total $5,950

Between the finished goods ($97,000) and the work in process ($5,950) we have accounted for

the total costs of $102,950.

Let’s try another mixing department example. Kesson Chemical Company produces bug

spray. This is accomplished by introducing chemicals into a large mixer and thoroughly mixing

the ingredients. Then an automatic bottling operation that is attached to the mixer bottles the bug

spray. At the start of June, Kesson, had 20,000 gallons of bug spray that were partially complete.

During June, 80,000 units were started and 70,000 units were completed. How do you cost the

completed units and the work in process ending inventory? Illustration 2.6 offers an explanation.

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 As you can see, the total cost to account for the production run in June is $725,000.

There were 20,000 units in beginning inventory and 80,000 units started in June, a total of

100,000 units. 70,000 units were completed, leaving 30,000 units 50% completed in work in

process inventory. Using our new best friend, equivalent units, we translate the physical units to

equivalent units. The units completed are 100% equivalent units i.e. they got a 100% dose of

direct materials, direct labor and overhead. The ending inventory of work in process (50%

complete) got a 100% dose of direct materials and 50% doses of direct labor and overhead. As a

result, the equivalent units are 15,000 for direct labor and 15,000 for overhead in the 30,000

physical units. Since the cost per equivalent unit is $8, we can cost the units completed as

70,000 X $8 = $560,000. For the work in process, the costs are:

Direct material 30,000 X $3 = $90,000

Direct labor 15,000 X $1 = $15,000

Overhead 15,000 X $4 = $60,000

Total $165,000
This accounts for our total production costs of $725,000 ($165,000 + $560,000).

Well, that’s it for process costing. As noted before, process costing is just like job order

costing except the unit receiving the costs are few in job order costing and many in process

costing. Now, after you have done the software, let’s move on to cost ­volume ­profit analysis in

Chapter 3.

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